Mr. Chairman, Mr. Rangel, and members of this committee, it is a pleasure to speak with you today about the President's FY 2000 budget.

The nation has moved from an era of large annual budget deficits to an era of budget surpluses for many years to come. This has resulted from the fiscal policy of the last six years, the economy it helped produce, and the ongoing interaction between the two. Rather than facing an annual requirement to reduce the deficit, we now have before us the opportunity to face the serious challenges for generations to come by making wise policy choices. These challenges lie primarily in the area of the economic and fiscal pressures created by the retirement of the baby boom generation. Meeting those challenges is exactly what the President's budget does. The core of this budget is fiscal discipline, and thereby increased national savings, in order to promote continuing economic growth and retirement security in the years ahead.

In 1992, the deficit reached a record of $290 billion, the Federal debt had quadrupled during the preceding twelve years, and both the deficit and debt were projected to rise substantially. The deficit binge has left us with publicly held debt of $3.7 trillion, and an annual debt service requirement that amounts to 15 percent of the budget. Now however, for the next 15 years, OMB forecasts cumulative unified surpluses of over $4.85 trillion.

It is important to note that transformation from deficits to surpluses has come about concurrent with tax burdens on typical working families being at record lows for recent decades. For a family of four with a median income, the federal income and payroll tax burden is at its lowest level in 21 years, in part because of the child tax credit enacted in the 1997 balanced budget plan. For a family of four with half the median income, the income and payroll tax burden is at its lowest level in 31 years, in part because of the 1993 expansion of the Earned Income Tax Credit for fifteen million families as well as the 1997 enactment of the child tax credit. And for a family of four with double the median income, the federal income tax burden is at its lowest level since 1973. While overall tax revenues have risen as a percentage of GDP, that is in part because higher income individuals have had large increases in incomes, resulting from, among other things, bonuses based on high stock prices and increased realizations of capital gains, and in part because of increased corporate earnings.

The President's proposal is to commit 62 percent of the unified surplus for the next 15 years to Social Security. This is an infusion of $2.8 trillion to the trust fund in addition to the $2.7 trillion of forecast off-budget surpluses generated by payroll taxes in excess of benefit payments. This infusion, including increased rates of return from investing one-fifth of the 62 percent of the unified surplus in equities, will push back the date of trust fund exhaustion from 2032 to 2055. Closing the remaining gap and thus assuring solvency over 75 years will require tough decisions to be made jointly by the President and Congress.

An additional 15 percent of the surplus would be allocated to Medicare. The President also proposes to devote 12 percent of the unified surplus to establishing a new system of Universal Savings Accounts. These accounts would provide a tax credit to millions of American workers to help them save for their retirement. A majority of workers could receive an automatic contribution. In addition, those who make voluntary contributions could receive a matching contribution to their USA account. The matching contribution would be more progressive than current tax subsidies for retirement savings -- helping most the workers who most need to increase retirement savings. By creating a retirement savings program for working Americans with individual and government contributions, all Americans will become savers and enjoy a more financially secure retirement.

The remaining 11 percent would be allocated to other priorities, including increased defense spending. Finally, the budget insists that none of the surpluses be used at all until we have put Social Security on sound financial footing for the long-term.

When President Clinton was elected, publicly held debt equaled 50 percent of GDP. As a result of the President's plan, by 2014, publicly held debt will decline to about 7 percent of GDP. This reduction in debt will have three effects. First, the government will not have to refinance as much federal debt and thereby will consume less of national savings, thus making capital more readily available to the private sector. That, in turn, will reduce interest rates and increase confidence in the economy, increasing economic growth, job creation and standards of living. Second, debt service costs will decline dramatically. When the President came into office debt service costs of the federal government in 2014 were projected to constitute 27 percent of the federal budget. Under the President's proposal, and because of the progress we have made to date, we estimate the debt service costs will be 2 percent of the federal budget in 2014. Third, the decrease in debt means the federal government will have a greatly improved capacity to access external capital should the need arise.

This is not the time, with the economy running so well, for major tax cuts that are not offset by other measures. Public debt reduction is an opportunity that we should not squander, and it will reap broader and more permanent economic prosperity than any tax cut could. Public debt reduction has many of the economic effects of a tax cut, but maintains the fiscal discipline necessary to meet future challenges. It is the only responsible course to take.

Targeted incentives

Thus, the President's Budget also proposes a fully funded package of about $34 billion in targeted tax reductions, including provisions to rebuild the nation's schools, make child and health care more affordable, revitalize communities, provide incentives for energy efficiency, promote retirement savings, provide for tax simplification, and extend expiring provisions.

More specifically, to enhance productivity and maintain our country's competitive position in the years ahead, and to provide relief for working families, the Administration proposes:

• increased funding for education, including tax credit bond programs totaling $25 billion to spur State and local government investment in elementary and secondary schools, expansion of the current-law tax incentive for employer-provided educational assistance, simplification and expansion of the deduction allowed for student loan interest payments, tax-free treatment for certain education awards, and a tax credit for certain workplace literacy and basic education programs;
  

• measures to make child care more affordable, by expanding the current-law child and dependent care tax credit and by providing a new employer credit to promote employee child care;
  

• providing tax relief (in the form of a $1,000 credit) to individuals with long-term care needs, or who care for others with such needs, and to workers with disabilities;
  

• measures to promote health insurance coverage for employees of small businesses;
  

• incentives to promote the livability and revitalization of urban and rural communities, including a tax credit bond program totaling $9.5 billion to help States and local governments finance environmental projects, a tax credit to attract new capital to businesses located in low-income communities, expansion of the current-law low-income housing tax credit program, and $3.6 billion in tax incentives to promote energy efficiency and reduce greenhouse gases;
  

• several provisions to expand, simplify, and increase the portability of retirement savings mechanisms, and to make it easier for individuals to save for retirement on their own; and
  

• extension of a recently enacted provision that allows individuals to claim nonrefundable tax credits -- such as the education credits and the $500 child credit -- without being affected by the alternative minimum tax; and
  

• extension of several tax provisions that are scheduled to expire, including the R&E tax credit, work opportunity and welfare-to-work tax credits, and the so-called "brownfields" expensing provision.

The President's plan also includes a package of provisions that would simplify the administration of the Federal tax laws.

The following is a more detailed summary of the tax incentive provisions included in the President's plan.

1. MAKE HEALTH CARE MORE AFFORDABLE

Long-term care and disabled workers credits.--Deductions available under current law for long-term care and work-related impairment expenses do not benefit taxpayers who claim the standard deduction and, even if a taxpayer itemizes deductions, do not cover all formal and informal costs of providing assistance to individuals with long-term care needs or to disabled individuals who work. In recognition of such formal and informal long-term care costs and their effect on a taxpayer's ability to pay taxes, the President's plan would allow taxpayers to claim a new long-term care credit of $1,000 if the taxpayer, a spouse, or an individual receiving support from (or residing with) the taxpayer has "long-term care needs." An individual generally would have "long-term care needs" if unable for at least six months to perform at least three activities of daily living without substantial assistance from another individual, or if unable to perform at least one activity of daily living or certain age appropriate activities due to severe cognitive impairment.

In addition, the President's plan would help compensate taxpayers with disabilities for costs associated with work (e.g., personal assistance or special transportation) by allowing taxpayers with earned income to claim a $1,000 credit if the taxpayer is unable for at least 12 months to perform at least one activity of daily living without substantial assistance from another individual.

To claim one (or possibly both) of the credits, taxpayers would be required to obtain a physician's certification to demonstrate the required level of long-term care needs, but would not be required to substantiate any particular out-of-pocket expenses. The proposed credits would be phased out -- in combination with the current-law $500 child credit -- for certain higher-income taxpayers.

Small business health plans.--The President's plan would make health care costs more affordable by assisting small businesses in their efforts to provide health insurance to employees. Small businesses generally face higher costs than do larger employers in providing health plans to their employees, which has led to a significantly higher percentage of small business employees being uninsured compared to the national average. Health benefit purchasing coalitions pool employer workforces and provide an opportunity to purchase health insurance at a reduced cost, but such coalitions have been hindered by limited access to capital. In response, the President's plan includes a special, temporary rule that would allow tax-exempt private foundations to make grants or loans prior to January 1, 2004, to qualified health benefit purchasing coalitions to support the coalition's initial operating expenses.

Moreover, the President's plan would allow employers that have fewer than 50 employees and that did not have an employee health plan during 1997 or 1998 to claim a 10- percent credit for certain premium payments made for employee health insurance purchased through a qualified coalition. The proposed credit would be allowed for health plans established before January 1, 2004, and would be allowed for contributions made during the first 24 months that an employer purchases health insurance through a qualified coalition.

2. EXPAND EDUCATION INITIATIVES

School construction and modernization .--Because many school systems lack sufficient fiscal capacity to respond to aging school buildings and growing enrollments, the President's plan includes a new tax credit bond program that would leverage Federal support to spur new State and local investment in elementary and secondary school modernization. Under this program, State and local governments (including U.S. possessions) would be authorized to issue up to $22 billion of "qualified school modernization bonds" ($11 billion in each of 2000 and 2001). One half of the $22 billion cap would be allocated among the 100 school districts with the largest number of children living in poverty and up to 25 additional school districts with particular needs of assistance. The remaining half of the $22 billion cap would be allocated among the States and Puerto Rico. In addition, $400 million of bonds ($200 million in each of 2000 and 2001) would be allocated for construction and renovation of Bureau of Indian Affairs funded schools.

A holder of these bonds would receive annual Federal income tax credits, set according to market interest rates by the Treasury Department, in lieu of interest being paid by the State or local government. At least 95 percent of the bond proceeds of a qualified school modernization bond must be used (generally within 3 years of the date of issuance) to finance public school construction or rehabilitation pursuant to a plan approved by the Department of Education. Issuers would be responsible for repayment of principal after a maximum term of 15 years.

The President's plan also provides for expansion of the current-law "qualified zone academy bond" program, by authorizing the issuance of an additional $2.4 billion of such bonds and allowing the bond proceeds to be used for new school construction.

Other education incentives.--To expand educational opportunities throughout a taxpayer's lifetime, the President's budget plan also includes the following provisions that build on current-law tax incentives for education: (1) extend section 127 exclusion for employer- provided educational assistance through the end of the year 2001 and expand the exclusion to apply to graduate-level courses (currently, the exclusion is limited to undergraduate courses beginning before June 1, 2000); (2) eliminate the current-law rule under section 221 that limits deductible student loan interest to interest paid only during the first 60 months that interest payments are required on a loan (this will simplify greatly the student loan interest deduction provision); (3) eliminate tax liability when Federal student loan balances are canceled after the student finishes making income-contingent payments on the loan; (4) provide tax-free treatment for certain awards under the National Health Service Corps scholarship and loan repayment programs, the Armed Forces Health Professions scholarship and loan repayment programs, and the Americorps loan repayment program; (5) provide for an allocated tax credit to encourage corporate sponsorship of qualified zone academies in designated empowerment zones and enterprise communities; and (6) allow employers to claim a 10-percent credit (up to $525 per eligible employee) for certain workplace literacy programs that provide basic skills instruction at or below the level of a high school degree or English literacy.

3. MAKING CHILD CARE MORE AFFORDABLE

Increase, expand and simplify the child and dependent care tax credit.--Many working parents cannot find affordable and safe child care. The needs of moderate-income families can best be served through an expansion of the current-law child and dependent care tax credit, which was last increased in 1982. The President's plan would increase the maximum credit rate from 30 percent to 50 percent, and would extend eligibility for the maximum credit rate to taxpayers with adjusted gross incomes of $30,000 (rather than $10,000 as under current law). The new 50-percent credit rate would be phased down gradually for taxpayers with adjusted gross incomes between $30,000 and $59,000. The credit rate would be 20 percent for taxpayers with adjusted gross incomes over $59,000.

In addition, to enable parents to make the best choices for caring for their infants, who require special care and attention, the President's plan would further expand the eligibility for the child and dependent care tax credit. Parents with infants under the age of one would be eligible for an additional credit amount, even if the parent stays at home to care for the infant rather than working outside the home and incurring out-of-pocket child care expenses. Under the proposal, a taxpayer who resides with his or her infant under the age of one would be deemed to have child care expenses of $500 ($1,000 for two or more infants under the age of one). Taxpayers residing with children under the age of one who also incur out-of-pocket child care expenses in order to work would simply add such out-of-pocket expenses to the deemed $500 (or $1,000) of child care expenses, and would then calculate the section 21 credit by multiplying deemed and actual out-of-pocket child care expenses by the applicable 20- to 50-percent credit rate.

The President's plan would simplify eligibility for the credit by eliminating the complicated household maintenance test under current law (except that a married taxpayer filing a separate return would still have to meet the current-law household maintenance test in order to qualify for the credit). In addition, to ensure that the credit retains its value over time, certain credit parameters would be indexed for inflation.

Employer-provided child care credit.--As part of the Administration's comprehensive initiative to address child care needs of working families, the President's plan would allow employers to claim a credit equal to 25 percent of expenses incurred to build or acquire a child care facility for employee use, or to provide child care services to children of employees directly or through a third party. Employers also would be entitled to a credit equal to 10 percent of expenses incurred to provide employees with child care resource and referral services. A taxpayer's total credit could not exceed $150,000 per taxable year.

4. INCENTIVES TO REVITALIZE COMMUNITIES

Better America Bonds.--Conventional tax-exempt bonds may not provide a deep enough subsidy to induce State and local governments to undertake environmental projects with diffuse public benefits. Accordingly, the President's plan includes a new tax credit bond program, under which States and local governments (including U.S. possessions and Native American tribal governments) would be authorized to issue an aggregate of $9.5 billion of "Better America Bonds." Similar to the President's school modernization bond proposal (discussed above) and the current-law qualified zone academy bonds, holders of such bonds would receive annual Federal income tax credits in lieu of interest being paid by the State or local government. At least 95 percent of the bond proceeds must be used (generally within 3 years of the date of issuance) to finance projects to protect open spaces or accomplish certain other qualified environmental purposes. The Environmental Protection Agency would allocate bond authority to particular environmental projects based on a competitive application process. Issuers of the bonds would be responsible for repayment of principal after a maximum term of 15 years.

New Markets Tax Credit.--Businesses located in low-income urban and rural communities often lack access to sufficient equity capital. To attract new capital to these businesses, taxpayers would be allowed a credit against Federal income taxes for certain investments made to acquire stock (or other equity interests) in a community development investment entity selected by the Treasury Department to receive a credit allocation. The Treasury Department would authorize selected community development entities to issue up to a total of $6 billion of equity interests with respect to which investors could claim a credit equal to approximately 25 percent (in present-value terms) of the investment.

Under the proposal, selected community development investment entities, in turn, would be required to use the investment proceeds to provide loans or equity capital to qualified active business located in low-income communities. Such businesses generally would be required to satisfy the requirements for "enterprise zone businesses" under current law and must be located in census tracts with either (1) poverty rates of at least 20 percent or (2) median family income which does not exceed 80 percent of metropolitan area family income (or 80 percent of non- metropolitan statewide family income in the case of a non-metropolitan census tract). There would be no requirement that employees of a qualified active business be residents of a low- income community.

Increase low-income housing tax credit per capita cap.--Most State agencies receive more qualified proposals for low-income rental housing than can be undertaken with the current- law State limitation for the low-income housing tax credit. This limitation has not changed since it was established in 1986. Accordingly, the President's plan would increase the current-law $1.25 per capita limitation for the low-income housing tax credit to $1.75 per capita. This increase would allow additional low-income housing to be provided but still would require that State agencies choose projects that meet specific housing needs.

Other provisions.--As additional incentives to revitalize communities, the President's plan would (1) enhance the current-law provisions that allow certain investment gains to be rolled over on a tax-free basis to purchase stock in a specialized small business investment company (SSBIC) and that provide a partial capital gains exclusion for the sale of such stock held for more than five years; and (2) provide that businesses located in the two new empowerment zones, with respect to which the zone designation takes effect on January 1, 2000 (i.e., Cleveland and Los Angeles), will be eligible to claim the empowerment zone wage credit for the full, ten-year period of zone designation, as is the case with the original nine empowerment zones designated in 1994.

5. ENERGY EFFICIENCY AND ENVIRONMENTAL IMPROVEMENT

In an effort to improve the environment, the President's budget proposes $3.6 billion in tax incentives to promote energy efficiency and to reduce emissions of greenhouse gases.

Energy-efficient buildings would be encouraged by a tax credit of up to $2,000 for the purchase of highly energy-efficient new homes, and by a 10 or 20 percent credit (subject to a cap) for the purchase of certain energy-efficient building equipment (fuel cells, electric heat pump water heaters, natural gas heat pumps, electric heat pumps, natural gas water heaters, and advanced central air conditioners). The credit for energy-efficient homes would apply to purchases in calendar years 2000 through 2004 and the credit for energy-efficient building equipment would apply to purchases in calendar years 2000 through 2003.

Transportation-related incentives would encourage the purchase of electric vehicles and highly energy-efficient hybrid vehicles. The current-law credit of up to $4,000 for the purchase of a qualifying electric vehicle would be extended through 2006, and a new credit of up to $4,000 would be allowed in calendar years 2003 through 2006 for purchases of fuel-efficient hybrid vehicles.

The Administration's budget proposals would also promote increased energy efficiency through the use of combined heat and power (CHP) technologies by allowing an 8-percent investment tax credit for qualifying CHP equipment placed in service in calendar years 2000 through 2002.

Finally, tax incentives would be provided for the increased use of renewable energy sources: a credit of up to $2,000 would be allowed for solar photovoltaic equipment placed in service during calendar years 2000 through 2006 and of up to $1,000 for solar hot water heating systems placed in service during calendar years 2000 through 2005. In addition, the current-law tax credit for electricity produced from wind or biomass would be extended for five years. For this purpose, eligible biomass sources would be expanded to include certain biomass derived from forest-related resources and agricultural sources, and a reduced credit would be allowed for co-firing biomass in coal plants.

6. EXPANDED RETIREMENT SAVINGS, SECURITY, AND PORTABILITY

With changing demographics, it is especially important to increase retirement savings. Much of the legislation enacted in recent years has been successful in expanding retirement savings, providing incentives to individuals and employers. Approximately two-thirds of the retirement savings in this country (exclusive of annuity contracts) is employer-provided retirement savings. Employer-provided pensions currently benefit 50 million workers. The President's budget encourages savings through employer-provided plans.

While the employer system is strong, we cannot be content. Half of all American workers -- more than 50 million people -- have no pension plan at all. Women have less pension coverage than men. Only 30 percent of all women aged 65 or older were receiving a pension in 1994 (either worker or survivor benefits) compared to 48 percent of men. An increasingly mobile workforce makes accumulating and managing retirement benefits more difficult. Workers frustrated by keeping track of their various retirement accounts are tempted to cash out their retirement benefits and spend these all important savings on current consumption. Two-thirds of workers receiving a lump sum distribution from a pension plan do not roll over the distribution into retirement savings.

We need to continue to promote retirement savings by enacting pension legislation to expand the number of people who will have employer-provided pensions, by simplifying the pension laws for business, by improving pension funding and making pensions more secure and portable for workers.

The President's budget includes several incentives to encourage the provision of retirement benefits by small business. First, a three-year tax credit is provided to encourage small businesses to set up retirement programs. Second, to make it easier for workers to make contributions to Individual Retirement Accounts (IRAS), employers would be encouraged to offer payroll deduction programs. Third, the President's plan provides a simplified defined benefit-type plan for small business, known as the "SMART Plan." The Administration's proposal is similar in many respects to the bipartisan "SAFE plan" proposal of Representatives Earl Pomeroy and Nancy Johnson. The SMART (Secure Money Annuity or Retirement Trust) plan combines many of the best features of defined benefit and defined contribution plans and provides another easy-to-administer pension option for small businesses. Most nondiscrimination rules and a number of other pension plan requirements would be waived for this new plan. SMART plans would be an option for most small businesses with 100 or fewer employees that do not offer (and have not offered during the last 5 years) a defined benefit or money purchase plan. Employers choosing a SMART plan would make contributions for all eligible workers (over 21 with at least $5,000 in W-2 earnings with the employer in that year and in two preceding consecutive years). Participants would be guaranteed a minimum annual benefit upon retirement, but could receive a larger benefit if the return on plan investments exceeds specified conservative assumptions (i.e., a 5 percent rate of return). The SMART benefit would generally be guaranteed by the Pension Benefit Guaranty Corporation, at a reduced premium.

To make it easier to consolidate retirement savings, the President's budget provides rules to permit eligible rollover distributions from a qualified retirement plan to be rolled over into a Section 403(b) tax-sheltered annuity or visa versa; to allow rollovers from non qualified deferred compensation plans of state or local government (Section 457 plans) to be rolled over into an IRA; to permit rollovers of IRAs into workplace retirement plans; to allow rollovers of after-tax contributions to new employer's defined contribution plan or an IRA if separate tracking of after-tax contribution is provided; to allow the Thrift Savings Plan (a retirement savings plan for federal government employees) to accept tax-free rollovers from private plans; and to allow employees of state and local governments to use funds in their retirement plans to purchase service credits in new plans without a taxable distribution. This allows teachers who often move between state and school districts in the course of their careers to more easily earn a pension reflecting a full career of employment in the state in which they end their career.

7. EXTENSION OF EXPIRING PROVISIONS

The President's plan includes the extension of several important tax incentive provisions that are scheduled to expire in 1999, including (1) a one-year extension of the R&E tax credit to apply to qualified research conducted before July 1, 2000 (and extension of the credit to qualified research conducted in Puerto Rico), and (2) one-year extensions of the work opportunity tax credit and welfare-to-work tax credit to cover employees who begin work before July 1, 2000.

The President's plan also proposes extending through the year 2001 the recently enacted tax credit for the first-time purchase of a principal residence in the District of Columbia (which currently is scheduled to expire at the end of the year 2000).

In addition, the President's plan would make permanent the so-called "brownfields" provision, which allows taxpayers to treat certain environmental remediation expenditures that would otherwise be chargeable to capital account as deductible in the year paid or incurred. The "brownfields" provision currently is scheduled to expire at the end of the year 2000.

AMT Relief

Of particular importance to individual taxpayers, the Administration proposes to extend, for two years, the provision enacted in 1998 that allows an individual to offset his or her regular tax liability by nonrefundable tax credits--such as the education credits and the child credit-- regardless of the amount of the individual's tentative minimum tax. The Administration is concerned that the individual alternative minimum tax (AMT) may impose financial and compliance burdens upon taxpayers that have few tax preference items and were not the originally intended targets of the AMT. In particular, the Administration is concerned that the individual AMT may act to erode the benefits of nonrefundable tax credits that are intended to provide relief for middle-income taxpayers. During the proposed extension period, the Administration hopes to work with Congress to develop a longer-term solution to the individual AMT problem.

8. SIMPLIFICATION PROVISIONS

The President's plan includes several other provisions that would simplify the administration of Federal tax laws. These provisions would: (1) extend the current-law rule for farmers to all self-employed individuals that allows individuals to elect to increase their self- employment income for purposes of obtaining social security coverage; (2) provide statutory hedging and other rules (generally codifying rules previously promulgated by the Treasury Department) to ensure that business property is treated as ordinary property; (3) clarify rules relating to certain disclaimers by donees of gifts or bequests; (4) simplify the foreign tax credit limitation for dividends from so-called "10/50 companies"; (5) eliminate the U.S. withholding tax on distributions from U.S. mutual funds that hold substantially all of their assets in cash or U.S. debt securities (or foreign debt securities that are not subject to withholding tax under foreign law); (6) expand the declaratory judgment relief available under current-law to charities to all organizations seeking tax-exempt status under section 501(c); and (6) simplify the active trade or business requirement for tax-free corporate spin-offs. The Administration hopes to work with the Congress to develop and enact additional, appropriate simplification measures.

9. MISCELLANEOUS PROVISIONS

Other targeted tax incentives included in the President's plan include a proposed extension and modification of the current-law Puerto Rico economic-activity credit, to provide a more efficient and effective tax incentive for the economic development of Puerto Rico.

In addition, to reduce the burdens faced by displaced workers, the President's plan would exclude up to $2,000 of certain severance payments from the income of the recipient. This exclusion would apply to payments received by an individual who was separated from service in connection with a reduction in the employer's work force, but only if the individual does not attain employment within six months of the separation from service at a compensation level that is at least 95 percent of the compensation the individual received before the separation from service and only if total severance payments received by the individual do not exceed $75,000.

To address the financial troubles of the steel industry, the President's plan would extend to 5 years the carryback period for the net operating loss (NOL) of a steel company. An eligible taxpayer could elect to forgo the 5-year carryback and apply the current-law carryback rules. The benefit proposed would feed directly into a financially troubled steel company's cash flow, providing immediate needed relief.

10. ELECTRICITY RESTRUCTURING

Restructuring the electric industry to encourage retail competition promises significant economic benefits to both business and household consumers of electricity. In order to reap the benefits of restructuring, steps must be taken to provide a level playing field for investor-owned and publicly-owned electric systems as well as to provide relief from the rules governing private use of tax-exempt bond-financed electric facilities in appropriate circumstances. The President's plan provides that no new facilities for electric generation or transmission may be financed with tax-exempt bonds. Distribution facilities may continue to be financed with tax-exempt bonds subject to existing private use rules. Distribution facilities are facilities operating at 69 kilovolts or less (including functionally related and subordinate property). In order to develop efficient nondiscriminatory transmission services, publicly-owned electric utility companies may be required to turn the operation of their transmission facilities over to independent systems operators or use those facilities in a manner that may violate the private use rules. In addition, as traditional service areas of both investor-owned and publicly-owned systems are opened to retail competition, the latter may find it necessary to enter into contracts with private users of electricity in order to prevent their generation facilities from becoming stranded costs. Without relief from the private use rules, publicly-owned electric systems may not choose to open their service areas to competition or to allow their transmission facilities to be operated by a private party.

In response, the President's plan provides that bonds issued to finance transmission facilities prior to the enactment of legislation to implement restructuring would continue their tax-exempt status if private use results from action pursuant to a Federal order requiring non- discriminatory open access to those facilities. In addition, bonds issued to finance generation or distribution facilities issued prior to enactment of such legislation would continue their tax- exempt status if private use results from retail competition, or if private use results from the issuer entering into a contract for the sale of electricity or use of its distribution property that will become effective after implementation of retail competition. Sale of facilities financed with tax- exempt bonds to private entities would continue to constitute a change in use. Bonds issued to refund, but not advance refund, bonds issued before enactment of legislation implementing restructuring would be permitted.

Finally, the President's plan would amend the rules applicable to nuclear decommissioning funds in order to address issues raised by the restructuring of the electric industry.

Revenue offsets

Our revenue offsets would curtail corporate tax shelters, and close loopholes in the tax law in the areas of financial products, corporate taxes, pass-through entities, tax accounting, cost recovery, insurance, exempt organizations, estate and gift taxation, taxation of international transactions, pensions, compliance, and others. These offsets generally would be effective with respect to a future date (e.g., date of first committee action, or date of enactment). We look forward to working with the committee to develop grandfather rules where appropriate.

Corporate Tax Shelters

The Administration believes there has been an increase in the use of corporate tax shelters and is concerned about this proliferation for several reasons. First, corporate tax shelters reduce the corporate tax base. Congress intended corporations to be a source of Federal revenue in enacting the various provisions of the corporate income tax. Questionable transactions that reduce corporate tax liability frustrate this intent. Moreover, corporate tax shelters erode the integrity of the tax system as a whole. A view that well-advised corporations can and do avoid their legal tax liabilities by engaging in transactions unavailable to most other taxpayers may lead to a perception of unfairness and, if unabated, may lead to a decrease in voluntary compliance. Finally, the significant resources used to create, implement and defend complex sheltering transactions are better used in productive activities. Similarly, the IRS must expend significant resources to combat such transactions.

To date, most attacks on corporate tax shelters have been targeted at specific transactions and have occurred on an ad-hoc, after-the-fact basis -- through legislative proposals, administrative guidance, and litigation. At the Treasury Department, a number of actions have been taken to address corporate tax shelters. For example, we've made legislative proposals aimed at section 357 basis creation abuses, which has advanced in both chambers, and liquidating REITs, which was enacted last year. On the regulatory front, we have issued guidance, such as the notice on stepped-down preferred, fast-pay, slow-pay transactions, and in litigation, we've won two important cases -- ACM and ASA. But we often hear that we are only hitting the tip of the iceberg.

Addressing corporate tax shelters on a transaction-by-transaction, ad hoc basis, however, raises certain concerns. First, it is not possible to identify and address all current and future sheltering transactions. Taxpayers with an appetite for corporate tax shelters will simply move from those transactions that are specifically prohibited by the new legislation to other transactions the treatment of which is less clear. Second, legislating on a piecemeal basis further complicates the Code and seemingly calls into question the viability of common law tax doctrines such as sham transaction, business purpose, economic substance and substance over form. Finally, using a transactional legislation approach to corporate tax shelters may embolden some promoters and participants to rush shelter products to market on the belief that any retroactive legislation would be applied only on a prospective basis.

The primary goal of any corporate tax shelter is to eliminate, reduce, or defer corporate income tax. To achieve this goal, corporate tax shelters are designed to manufacture tax benefits that can be used to offset unrelated income of the taxpayer or to create tax-favored or tax-exempt economic income. Most corporate tax shelters rely on one or more discontinuities in the tax law, or exploit a provision in the Code or Treasury regulations in a manner not intended by Congress or the Treasury Department.

Corporate tax shelters may take several forms. For this reason, they are hard to define. However, corporate tax shelters often share certain common characteristics. For example, through hedges, circular cash flows, defeasements, or other devices, corporate participants in a shelter often are insulated from any risk of economic loss or opportunity for economic gain with respect to the sheltering transaction. Thus, corporate tax shelters are transactions without significant economic substance, entered into principally to achieve a desired tax result. Similarly, the financial accounting treatment of a shelter generally is significantly more favorable than the corresponding tax treatment; that is, the shelter produces a tax "loss" that is not reflected as a book loss. However, the corporate tax shelter may produce a book earnings benefit by reducing the corporation's effective tax rate.

Corporate tax shelter schemes often are marketed by their designers or promoters to multiple corporate taxpayers and often involve property or transactions unrelated to the corporate participant's core business. These two features may distinguish corporate tax shelters from traditional tax planning.

Many corporate tax shelters involve arrangements between corporate taxpayers and persons not subject to U.S. tax such that these tax indifferent parties absorb the taxable income from the transaction, leaving tax losses to be allocated to the corporation. The tax indifferent parties in effect "rent" their tax exempt status in return for a accommodation fee or an above- market return on investment. Tax indifferent parties include foreign persons, tax-exempt organizations, Native American tribal organizations, and taxpayers with loss or credit carryforwards.

Taxpayers entering into corporate tax shelter transactions often view such transactions as risky because the expected tax benefits may be successfully challenged. To protect against such risk, purchasers of corporate tax shelters often require the seller or a counterparty to enter into a tax benefit protection arrangement. Thus, corporate tax shelters are often associated with high transactions costs, contingent or refundable fees, unwind clauses, or insured results.

These themes run through our budget proposals and, we hope, help us to focus on finding broader, ex ante solutions to the corporate tax shelter problem.

The Administration therefore proposes several remedies to curb the growth of corporate tax shelters. We propose more general remedies to deter corporations from entering into any sheltering transactions. These proposals would disallow any tax benefit created in a corporate tax shelter, as so defined, and would address common characteristics found in corporate tax shelters as described above. Also, all the parties to a structured transaction would have an incentive, under our proposals, to assure that the transaction comports with established principles.

The Treasury Department recognizes that this more general approach to corporate tax shelters raises certain concerns. Applying various substantive and procedural rules to a "corporate tax shelter" or a "tax avoidance transaction" requires definitions of such terms. As described in greater detail below, the Administration's proposals define these terms. Critics of the proposals have suggested that these definitions are too broad or may create too much uncertainty and thus may inhibit otherwise legitimate transactions. The Treasury Department does not intend to affect legitimate business transactions and looks forward to working with the tax-writing committees in refining the corporate tax shelter proposals. However, some level of uncertainty is unavoidable with respect to complex transactions. In addition, the definition of corporate tax shelter as used in our proposals is narrower and therefore less uncertain than other definitions and formulations used in the Code. Moreover, the definition we have proposed is similar to existing articulations of various judicial doctrines and may be viewed as largely enforcing the judicially-created concept of economic substance of current law. Finally, some amount of uncertainty may be useful in discouraging taxpayers from venturing to the edge, thereby risking going over the edge, of established principles.

The Administration's proposals that generally would apply to corporate tax shelters are: Deny certain tax benefits in tax avoidance transactions.--Under current law, if a person acquires control of a corporation or a corporation acquires carryover basis property of a corporation not controlled by the acquiring corporation or its shareholders, and the principal purpose for such acquisition is evasion or avoidance of Federal income tax by securing certain tax benefits, the Secretary may disallow such benefits to the extent necessary to eliminate such evasion or avoidance of tax. However, this current rule has been interpreted narrowly. The Administration proposes to expand the current rules to authorize the Secretary to disallow a deduction, credit, exclusion, or other allowance obtained by a corporation in a tax avoidance transaction.

For this purpose, a tax avoidance transaction would be defined as any transaction in which the reasonably expected pre-tax profit (determined on a present value basis, after taking into account foreign taxes as expenses and transaction costs) of the transaction is insignificant relative to the reasonably expected tax benefits (i.e., tax benefits in excess of the tax liability arising from the transaction, determined on a present value basis) of such transaction. In addition, a tax avoidance transaction would be defined to cover transactions involving the improper elimination or significant reduction of tax on economic income. The proposal would not apply to tax benefits clearly contemplated by the applicable current-law provision (e.g., the low-income housing tax credit).

Modify substantial understatement penalty for corporate tax shelters.--The current 20-percent substantial understatement penalty imposed on corporate tax shelter items can be avoided if the corporate taxpayer had reasonable cause for the tax treatment of the item and good faith. The Administration proposes to increase the substantial understatement penalty on corporate tax shelter items to 40 percent. The penalty will be reduced to 20 percent if the corporate taxpayer discloses to the National Office of the Internal Revenue Service within 30 days of the closing of the transaction appropriate documents describing the corporate tax shelter and files a statement with, and provides adequate disclosure on, its tax return. The penalty could not be avoided by a showing of reasonable cause and good faith. For this purpose, a corporate tax shelter would be defined as any entity, plan, or arrangement (to be determined based on all the facts and circumstances) in which a direct or indirect corporate participant attempts to obtain a tax benefit in a tax avoidance transaction.

Deny deductions for certain tax advice and impose an excise tax on certain fees received.--The proposal would deny a deduction for fees paid or accrued in connection with the promotion of corporate tax shelters and the rendering of certain tax advice related to corporate tax shelters. The proposal would also impose a 25-percent excise tax on fees received in connection with the promotion of corporate tax shelters and the rendering of certain tax advice related to corporate tax shelters.

Impose excise tax on certain rescission provisions and provisions guaranteeing tax benefits.--The Administration proposes to impose on the purchaser of a corporate tax shelter an excise tax of 25 percent on the maximum payment to be made under the arrangement. For this purpose, a tax benefit protection arrangement would include certain rescission clauses, guarantee of tax benefits arrangement or any other arrangement that has the same economic effect (e.g., insurance purchased with respect to the transaction).

Preclude taxpayers from taking tax positions inconsistent with the form of their transactions.--Under current law, if a taxpayer enters into a transaction in which the economic substance and the legal form are different, the taxpayer may take the position that, notwithstanding the form of the transaction, the substance is controlling for Federal income tax purposes. Many taxpayers enter into such transactions in order to arbitrage tax and regulatory laws. Under the proposal, except to the extent the taxpayer discloses the inconsistent position on its tax return, a corporate taxpayer, but not the Internal Revenue Service, would be precluded from taking any position (on a tax return or otherwise) that the Federal income tax treatment of a transaction is different from that dictated by its form, if a tax indifferent person has a direct or indirect interest in such transaction.

Tax income from corporate tax shelters involving tax-indifferent parties.--The proposal would provide that any income received by a tax-indifferent person with respect to a corporate tax shelter would be taxable, either to the tax-indifferent party or to the corporate participant.

The Administration also proposes to amend the substantive law related to specific transactions that the Treasury Department has identified as giving rise to corporate tax shelters. No inference is intended as to the treatment of any of these transactions under current law.

Require accrual of income on forward sale of corporate stock.--There is little substantive difference between a corporate issuer's current sale of its stock for a deferred payment and an issuer's forward sale of the same stock. In both cases, a portion of the deferred payment compensates the issuer for the time-value of money during the term of the contract. Under current law, the issuer must recognize the time-value element of the deferred payment as interest if the transaction is a current sale for deferred payment but not if the transaction is a forward contract. Under the proposal, the issuer would be required to recognize the time-value element of the forward contract as well.

Modify treatment of built-in losses and other attribute trafficking.--Under current law, a taxpayer that becomes subject to U.S. taxation may take the position that it determines its beginning bases in its assets under U.S. tax principles as if the taxpayer had historically been subject to U.S. tax. Other tax attributes are computed similarly. A taxpayer may thus "import'" built-in losses or other favorable tax attributes incurred outside U.S. taxing jurisdiction (e.g., from foreign or tax-exempt parties) to offset income or gain that would otherwise be subject to U.S. tax. The proposal would prevent the importation of attributes by eliminating tax attributes (including built-in items) and marking to market bases when an entity or an asset becomes relevant for U.S. tax purposes. This proposal would be effective for transactions in which assets or entities become relevant for U.S. tax purposes on or after the date of enactment.

Modify treatment of ESOP as S corporation shareholder.--Pursuant to provisions enacted in 1996 and 1997, an employee stock ownership plan (ESOP) may be a shareholder of an S corporation and the ESOP's share of the income of the S corporation is not subject to tax until distributed to the plan beneficiaries. The Administration proposes to require an ESOP to pay tax on S corporation income (including capital gains on the sale of stock) as the income is earned and to allow the ESOP a deduction for distributions of such income to plan beneficiaries.

Prevent serial liquidation of U.S. subsidiaries of foreign corporations.--Dividends from a U.S. subsidiary to its foreign parent corporation are subject to U.S. withholding tax. In contrast, if a domestic corporation distributes earnings in a tax-free liquidation, the foreign shareholder generally is not subject to any withholding tax. Some foreign corporations attempt to avoid dividend withholding by serially forming and liquidating holding companies for their U.S. subsidiaries. The proposal would impose withholding tax on any distribution made to a foreign corporation in complete liquidation of a U.S. holding company if the holding company was in existence for less than five years. The proposal would also achieve a similar result with respect to serial terminations of U.S. branches.

Prevent capital gains avoidance through basis shift transactions involving foreign shareholders.--To prevent taxpayers from attempting to offset capital gains by generating artificial capital losses through basis shift transactions involving foreign shareholders, the Administration proposes to treat the portion of a dividend that is not subject to current U.S. tax as a nontaxed portion and thus subject to the basis reduction rules applicable to extraordinary dividends. Similar rules would apply in the event that the foreign shareholder is not a corporation.

Limit inappropriate tax benefits for lessors of tax-exempt use property.--The Administration is concerned that certain structures involving tax-exempt use property are being used to generate inappropriate tax benefits for lessors. The proposal would deny a lessor the ability to recognize a net loss from a leasing transaction involving tax-exempt use property during the lease term. A lessor would be able to carry forward a net loss from a leasing transaction and use it to offset net gains from the transaction in subsequent years. This proposal would be effective for leasing transactions entered into on or after the date of enactment.

Prevent mismatching of deductions and income inclusions in transactions with related foreign persons.--The Treasury Department has learned of certain structured transactions designed to allow taxpayers inappropriately to take advantage of the certain current-law rules by accruing deductions to related foreign personal holding company (FPHC), controlled foreign corporation (CFC) or passive foreign investment company (PFIC) without the U.S. owners of such related entities taking into account for U.S. tax purposes an amount of income appropriate to the accrual. This results in an improper mismatch of deductions and income. The proposal would provide that deductions for amounts accrued but unpaid to related foreign CFCs, PFICs or FPHCs would be allowable only to the extent the amounts accrued by the payor are, for U.S. tax purposes, reflected in the income of the direct or indirect U.S. owners of the related foreign person. The proposal would contain an exception for certain short term transactions entered into in the ordinary course of business.

Restrict basis creation through section 357(c).--A transferor generally is required to recognize gain on a transfer of property in certain tax-free exchanges to the extent that the sum of the liabilities assumed, plus those to which the transferred property is subject, exceeds the basis in the property. This gain recognition to the transferor generally increases the basis of the transferred property in the hands of the transferee. If a recourse liability is secured by multiple assets, it is unclear under current law whether a transfer of one asset where the transferor remains liable is a transfer of property "subject to the liability." Similar issues exist with respect to nonrecourse liabilities. Under the Administration's proposal, the distinction between the assumption of a liability and the acquisition of an asset subject to a liability generally would be eliminated. The transferor's recognition of gain as a result of assumption of liability would not increase the transferee's basis in the transferred asset to an amount in excess of its fair market value. Moreover, if no person is subject to U.S. tax on gain recognized as the result of the assumption of a nonrecourse liability, then the transferee's basis in the transferred assets would be increased only to the extent such basis would be increased if the transferee had assumed only a ratable portion of the liability, based on the relative fair market values of all assets subject to such nonrecourse liability.

Modify anti-abuse rule related to assumption of liabilities.--The assumption of a liability in an otherwise tax-free transaction is treated as boot to the transferor if the principal purpose of having the transferee assume the liability was the avoidance of tax on the exchange. The current language is inadequate to address the avoidance concerns that underlie the provision. The Administration proposes to modify the anti-abuse rule by deleting the limitation that it only applies to tax avoidance on the exchange itself, and changing "the principal purpose" standard to "a principal purpose."

Modify corporate-owned life insurance (COLI) rules.--In general, interest on policy loans or other indebtedness with respect to life insurance, endowment or annuity contracts is not deductible unless the insurance contract insures the life of a "key person" of a business. In addition, the interest deductions of a business generally are reduced under a proration rule if the business owns or is a direct or indirect beneficiary with respect to certain insurance contracts. The COLI proration rules generally do not apply if the contract covers an individual who is a 20- percent owner of the business or is an officer, director, or employee of such business. These exceptions under current law still permit leveraged businesses to fund significant amounts of deductible interest and other expenses with tax-exempt or tax-deferred inside buildup on contracts insuring certain classes of individuals. The Administration proposes to repeal the exception under the COLI proration rules for contracts insuring employees, officers or directors (other than 20-percent owners) of the business. The proposal also would conform the key person exception for disallowed interest deductions attributable to policy loans and other indebtedness with respect to life insurance contracts to the 20-percent owner exception in the COLI proration rules.

Other Revenue Provisions

In addition to the general and specific corporate tax shelter proposals, the Administration's budget contains other revenue raising proposals that are designed to remove unwarranted tax benefits, ameliorate discontinuities of current law, provide simplification and improve compliance. Some of these proposals are described below.

Proposals Relating to Financial Products

The proposals relating to financial products narrowly target certain transactions and business practices that inappropriately exploit existing tax rules. Three of the proposals address the timing of income from debt instruments. Other proposals address specific financial products transactions that are designed to achieve tax results that are significantly better than the results that would be obtained by entering into economically equivalent transactions. At the same time, a number of these proposals contain provisions that are designed to simplify existing law and provide relief for taxpayers in cases where the literal application of the existing rules can produce an uneconomic result.

Mismeasurement of economic income.--The tax rules that apply to debt instruments generally require both the issuer and the holder of a debt instrument to recognize interest income and expense over the term of the instrument regardless of when the interest is paid. If the debt instrument is issued at a discount (that is, it is issued for an amount that is less than the amount that must be repaid), the discount functions as interest--as compensation for the use of money. Recognizing this fact, the existing tax rules require both parties to account for this discount as interest over the life of the debt instrument.

The Administration's budget contains three proposals that are designed to reduce the mismeasurement of economic income on debt instruments: (1) a rule that requires cash-method banks to accrue interest income on short-term obligations, (2) rules that require accrual method taxpayers to accrue market discount, and (3) a rule that requires the issuer in a debt-for-debt exchange to spread the interest expense incurred in the exchange over the term of the newly- issued debt instrument.

Specific transactions designed to exploit current rules.--There are a number of strategies involving financial products that are designed to give a taxpayer the "economics" of a particular transaction without the tax consequences of the transaction itself. For example, so- called "hedge fund swaps" are designed to give an investor the "economics" of owning a partnership interest in a hedge fund without the tax consequences of being a partner. These swaps purportedly allow investors to defer the recognition of income until the end of the swap term and to convert ordinary income into long-term capital gain.

Another strategy involves the used of structured financial products that allow investors to monetize appreciated financial positions without recognizing gain. If a taxpayer holds an appreciated financial position in personal property and enters into a structured financial product that substantially reduces the taxpayer's risk of loss in the appreciated position, the taxpayer may be able to borrow against the combined position without recognizing gain. Under current law, unless the borrowing is "incurred to purchase or carry" the structured financial product, the taxpayer may deduct its interest expense on the borrowing even though the taxpayer has not included the gain from the appreciated position.

The Administration's budget contains proposals that are designed to eliminate the inappropriate tax benefit these transactions create. The "constructive ownership" proposal would limit the amount of long-term capital gain a taxpayer could recognize from a hedge fund swap to the amount of long-term capital gain that would have been recognized if the investor had invested in the hedge fund directly. Another proposal would clarify that a taxpayer cannot currently deduct expenses (included interest expenses) from a transaction that monetizes an appreciated financial position without triggering current gain recognition.

Proposals Relating to Pass-through Entities

There are five coordinated proposals relating to basis adjustments and gain recognition in the partnership area. The proposals have three purposes: simplification, rationalization, and prevention of tax avoidance. The proposals accomplish these goals through a variety of means. In one proposal, the ability of taxpayers to elect whether or not to adjust the basis of partnership assets is eliminated in a situation where the election is leading to tax abuses. In another proposal, we would limit basis adjustments with respect to particular types of property, which enables us, in a different proposal, to repeal a provision that has been widely criticized as overly complex and irrational.

In addition to the partnership proposals, two REIT proposals are included in the budget. One proposal allows REITs to conduct expanded business activities in situations where a corporate level tax will be collected with respect to such activities. The other REIT proposal limits closely held REITs, which have been the primary vehicle for carrying out such corporate tax shelters as step-down preferred stock and the liquidating REIT transactions.

A final proposal in the pass-through area would impose a tax on gain when a large C corporation converts to an S corporation.

Proposals Relating to Corporate Provisions

The corporate proposals focus on a developing trend in structuring dispositions of assets or stock that technically qualify as tax-free transactions, but circumvent the repeal of General Utilities by allowing corporations to "sell" appreciated property without recognizing any gain. There has been a proliferation of highly publicized transactions in which corporations exploit the purposes of the tax-free reorganization provisions, (i.e., to allow a corporation to change its form when the taxpayer's investment remains in corporate solution), to maximize their ability to cash out of their investments and minimize the amount of tax paid. In addition, the corporate proposals attempt to simplify the law and prevent whipsaw of the government in certain tax-free transactions.

Modify tax-free treatment for mere adjustments in form.--In order for an acquisition or distribution of appreciated assets to qualify as wholly or partly tax-free, the transaction must satisfy a series of relatively stringent requirements. If the transaction fails to satisfy the requirements, it will be taxed in accordance with the general recognition principles of the Code. After the repeal of General Utilities, there are few opportunities to dispose of appreciated assets without a tax liability, and our proposals would help to ensure that those remaining exceptions to the repeal of General Utilities are not circumvented. The provisions of the Code that allow for tax-free treatment date back to the early years of the tax system and did not contemplate the creative tax planning that has taken place in the last several years. As a result, many of the corporate tax provisions have been manipulated, resulting in avoidance of tax.

The Administration's budget contains several proposals that are designed to eliminate opportunities under current law for corporations to achieve tax-free treatment for transactions that should be taxable. The proposals include (1) modifying the "control" test for purposes of tax-free incorporations, distributions and reorganizations to include a value component so that corporations may not "sell" a significant amount of the value of the corporation while continuing to satisfy the current law control test that focuses solely on voting power, (2) requiring gain recognition upon the issuance of "tracking stock" or a recapitalization of stock or securities into tracking stock, and (3) requiring gain recognition in downstream transactions in which a corporation that holds stock in another corporation transfers its assets to that corporation in exchange for stock.

Preventing taxpayers from taking inconsistent positions in certain nonrecognition transactions.--No gain or loss is recognized upon the transfer of property to a controlled corporation in exchange for stock. There is an inconsistency in the treatment by the Internal Revenue Service and the Claims Court as to the treatment of a transfer of less than all substantial rights to use intangible property. Accordingly, transferor and transferee corporations have taken the position that best achieves their tax goals. The proposal would eliminate this whipsaw potential by treating any transfer of an interest in intangible property as a tax-free transfer and requiring allocation of basis between the retained rights and the transferred rights based upon respective fair market values.

Proposals Relating to Tax Accounting and Cost Recovery

The Administration's budget contains measures that are principally designed to improve measurement of income by eliminating methods of accounting that result in a mismeasurement of economic income or provide disparate treatment among similarly situated taxpayers.

Repeal installment method for accrual basis taxpayers.--The proposal would repeal the installment method of accounting for accrual method taxpayers (other that those taxpayers that benefit from dealer disposition exceptions under current law) and eliminate inadequacies in the installment method pledging rules in order to better reflect the economic results of a taxpayer's business during the taxable year.

Apply uniform capitalization rules to tollers.--To eliminate the disparate treatment between manufacturers and tollers and better reflect the income of tollers, the proposal would require tollers (other than small businesses) to capitalize their direct costs and an allocable portion of their indirect costs to property tolled.

Provide consistent amortization periods for intangibles.--To encourage the formation of new businesses, the proposal would allow a taxpayer to elect to deduct up to $5,000 each of start-up and organizational expenditures. Start-up and organizational expenditures not currently deductible would be amortized over a 15-year period consistent with the amortization period for acquired intangibles.

Clarify recovery period of utility grading costs.--The proposal would clarify and rationalize current law by assigning electric and gas utility clearing and grading costs incurred to locate transmission and distribution lines and pipelines to the class life assigned to the benefitted assets, giving these costs a recovery period of 20 years and 15 years, respectively. The class life assigned to the benefitted assets is a more appropriate estimate of the useful life of these costs, and thus will improve measurement of the utility's income.

Deny change in method treatment to tax-free formations.-The proposal would eliminate abuses with respect to changes in accounting methods by expanding the transactions to which the carryover of method of accounting rules apply to include tax-free contributions to corporations and partnerships.

Deny deduction for punitive damages.--The deductibility of punitive damage payments under current law undermines the role of such damages in discouraging and penalizing certain undesirable actions or activities. The proposal would disallow any deduction for punitive damages to conform the tax treatment to that of other payments, such as penalties and fines, that are also intended to discourage violations of public policy.

Disallow interest on debt allocable to tax-exempt obligations.--Under current law, security dealers and financial intermediaries other than banks are able to reduce their tax liabilities inappropriately through double Federal tax benefits of interest expense deductions and tax-exempt interest income, notwithstanding that they operate similarly to banks. The proposal would eliminate the disparate treatment between banks and financial intermediaries, such as security dealers and other financial intermediaries, by providing that a financial intermediary investing in tax-exempt obligations would be disallowed deductions for a portion of its interest expense equal to the portion of its total assets that is comprised of tax-exempt investments.

Eliminate the income recognition exception for accrual method service providers.-- Under current law, accrual method service providers are provided a special exception to the general accrual rules that permit them, in effect, to reduce current taxable income by an estimate of future bad debt losses. This method of estimation results in a mismeasurement of a taxpayer's economic income and, because this tax benefit only applies to amounts to be received for the performance of services, discriminates in favor of service providers. The proposal would repeal the special exception for accrual method service providers.

Repeal lower-of-cost-or-market inventory accounting method.--.The allowance of write-downs under the lower-of-cost or market (LCM) method or subnormal goods method is an inappropriate exception from the realization principle and is essentially a one-way mark-to- market method that understates taxable income. The proposal would repeal the LCM and subnormal goods methods.

Proposals Relating to Insurance

The Administration's budget contains proposals to more accurately measure the economic income of insurance companies by updating and modernizing certain provisions of current law. The proposals would (1) require recapture of policyholder surplus accounts, (2) modify rules for capitalizing policy acquisition costs of life insurance companies, and (3) increase the proration percentage for property casualty (P&C) insurance companies.

Between 1959 and 1984, stock life insurance companies deferred tax on a portion of their profits. These untaxed profits were added to a policyholders surplus account (PSA). In 1984, Congress precluded life insurance companies from continuing to defer tax on future profits through PSAs. However, companies were permitted to continue to defer tax on their existing PSAs. Most pre-1984 policies have terminated so there is no remaining justification for allowing these companies to continue to defer tax on profits they earned between 1959 and 1984.

Under current law, pursuant to a provision enacted in 1990, insurance companies capitalize varying percentages of their net premiums for certain types of insurance contracts, and generally amortize these amounts over 10 years (five years for small companies). These capitalized amounts are intended to serve as proxies for each company's actual commissions and other policy acquisition expenses. However, data reported by insurance companies to State insurance regulators each year indicates that the insurance industry is capitalizing less than half of its policy acquisition costs, which results in a mismatch of income and deductions. The Administration proposes that insurance companies be required to capitalize modified percentages of their net premiums for certain lines of business.

In computing their underwriting income, P&C insurance companies deduct reserves for losses and loss expenses incurred. These loss reserves are funded in part with the company's investment income. In 1986, Congress reduced the reserve deductions of P&C insurance companies by 15 percent of the tax-exempt interest or the deductible portion of certain dividends received. In 1997, Congress expanded the 15-percent proration rule to apply to the inside buildup on certain insurance contracts. The existing 15-percent proration rule still enables P&C insurance companies to fund a substantial portion of their deductible reserves with tax-exempt or tax- deferred income. Other financial intermediaries, such as life insurance companies, banks and brokerage firms, are subject to more stringent proration rules that substantially reduce or eliminate their ability to use tax-exempt or tax-deferred investments to fund currently deductible reserves or deductible interest expense.

Proposals Relating to International Provisions

The Administration's budget contains proposals designed to ensure that economically similar international transactions are taxed in a similar manner, prevent manipulation and inappropriate use of exemptions from U.S. tax, allocate income between U.S. and foreign sources in a more appropriate manner, and determine the foreign tax credit in a more accurate manner. Specific proposals include:

Expand section 864(c)(4)(B) to interest and dividend equivalents.--Under U.S. domestic law, a foreign person is subject to taxation in the United States on a net income basis with respect to income that is effectively connected with a U.S. trade or business (ECI). The test for determining whether income is effectively connected to a U.S. trade or business differs depending on whether the income at issue is U.S. source or foreign source. Only enumerated types of foreign source income -- rents, royalties, dividends, interest, gains from the sale of inventory property, and insurance income -- constitute ECI, and only in certain circumstances. The proposal would expand the categories of foreign-source income that could constitute ECI to include interest equivalents (including letter of credit fees) and dividend equivalents in order to eliminate arbitrary distinctions between economically equivalent transactions.

Recapture overall foreign losses upon disposition of CFC stock.--If deductions against foreign income result in (or increase) an overall foreign loss which is then set against U.S. income, current law has recapture rules that require subsequent foreign income or gain to be recharacterized as domestic. Recapture can take place when directly-owned foreign assets are disposed of. However, there may be no recapture when stock in a controlled foreign corporation (CFC) is disposed of. The proposal would correct that asymmetry by providing that property subject to the recapture rules upon disposition would include stock in a CFC.

Amend 80/20 company rules.-Interest or dividends paid by a so-called "80/20 company" generally are partially or fully exempt from U.S. withholding tax. A U.S. corporation is treated as an 80/20 company if at least 80 percent of the gross income of the corporation for the three year period preceding the year of a dividend is foreign source income attributable to the active conduct of a foreign trade or business (or the foreign business of a subsidiary). Certain foreign multinationals improperly seek to exploit the rules applicable to 80/20 companies in order to avoid U.S. withholding tax liability on earnings of U.S. subsidiaries that are distributed abroad.

The proposal would prevent taxpayers from avoiding withholding tax through manipulations of these rules.

Modify foreign office material participation exception.--In the case of a sale of inventory property that is attributable to a nonresident's office or other fixed place of business within the United States, the sales income is generally treated as U.S. source. The income is treated as foreign source, however, if the inventory is sold for use, disposition, or consumption outside the United States and the nonresident's foreign office or other fixed place of business materially participates in the sale. Income that is treated as foreign source under this rule is not treated as effectively connected with a U.S. trade or business and is not subject to U.S. tax. The proposal would provide that the foreign source exception shall apply only if an income tax equal to at least 10 percent of the income from the sale is actually paid to a foreign country with respect to such income.

Stop abuses of CFC exception under section 833. A foreign corporation is subject to a four-percent tax on its United States source gross transportation income. The tax will not apply if the corporation is organized in a country (an "exemption country") that grants an equivalent tax exemption to U.S. shipping companies or is a controlled foreign corporation (the "CFC exception"). The premise for the CFC exception is that the U.S. shareholders of a CFC will be subject to current U.S. income taxation on their share of the foreign corporation's shipping income and, thus, the four-percent tax should not apply if the corporation is organized in an exemption country. Residents of non-exemption countries, however, can achieve CFC status for their shipping companies simply by owning the corporations through U.S. partnerships. The proposal would stop this abuse by narrowing the CFC exception.

Replace sales-source rules with activity-based rules.--If inventory is manufactured in the United States and sold abroad, Treasury regulations provide that 50 percent of the income from such sales is treated as earned by production activities and 50 percent by sales activities. The income from the production activities is sourced on the basis of the location of assets held or used to produce the income. The income from the sales activity (the remaining 50 percent) is sourced based on where title to the inventory transfers. If inventory is purchased in the United States and sold abroad, 100 percent of the sales income generally is deemed to be foreign source. These rules generally produce more foreign source income for Unites States tax purposes than is subject to foreign tax and thereby allow U.S. exporters that operate in high-tax foreign countries to credit tax in excess of the U.S. rate against their U.S. tax liability. The proposal would require that the allocation between production activities and sales activities be based on actual economic activity.

Modify rules relating to foreign oil and gas extraction income.--To be eligible for the U.S. foreign tax credit, a foreign levy must be the substantial equivalent of an income tax in the U.S. sense, regardless of the label the foreign government attaches to it. Current law recognizes the distinction between creditable taxes and non-creditable payments for specific economic benefit but fails to achieve the appropriate split between the two in a case where a foreign country imposes a levy on, for example, oil and gas income only, but has no generally imposed income tax. The proposal would treat as taxes payments by a dual-capacity taxpayer to a foreign country that would otherwise qualify as income taxes or "in lieu of" taxes, only if there is a "generally applicable income tax" in that country. Where the foreign country does generally impose an income tax, as under present law, credits would be allowed up to the level of taxation that would be imposed under that general tax, so long as the tax satisfies the new statutory definition of a "generally applicable income tax." The proposal also would create a new foreign tax credit basket for foreign oil and gas income.

Miscellaneous revenue proposals

The President's budget also includes miscellaneous revenue proposals, many of which were proposed in prior budgets. Some of these proposals are: (1) taxing the investment income of trade associations, (2) the repeal of the percentage depletion for non-fuel minerals mined on Federal lands, (3) the reinstatement of the oil spill excise tax, with an increase in the full funding limitation from $1 billion to $5 billion, (4) a modification of the FUTA deposit requirement, (5) simplification of the foster child definition for purposes of the earned income tax credit, (6) an excise tax on the purchase of structured settlements, (7) several proposals to improve compliance, (8) repeal of the de minimis rental income rule, and (9) certain pension and compensation-related provisions. The budget proposals also include various other provisions that affect receipts. These are the reinstatement of the environmental tax imposed on corporate taxable income ($2.7 billion), reinstatement of the Superfund excise taxes ($3.8 billion), and receipts from tobacco legislation ($34.5 billion). The budget also converts a portion of the aviation excise taxes into cost-based user fees and replaces the Harbor Maintenance Tax with a user fee.

In conclusion, Mr. Chairman and Mr. Rangel, and members of this committee, the Administration looks forward to working with you as you examine our proposals. We want to thank you for your comments about our corporate tax shelter proposals, and your willingness to listen.